Friday, September 19, 2008

How bad did things just get?

So bad that for a while yesterday a key part of the financial system stopped working.

Many Australian, Asian and European superannuation funds and corporations will not invest in the US unless they can hedge their currency exposure.

Hedging means protecting yourself against movements in exchange rates.

It comes at a cost, but it has always been available - until yesterday.

Yesterday it became impossible to hedge at any cost. No-one with access to US dollars would agree to use them in the forward market.

It meant no trade on any terms until the US market opened for business and the US Federal Reserve once again flooded its financial system with dollars...

The implications were beginning to sink in. The US dollar, previously the most- tradeable currency in the world, wasn't safe to deal in.

Because the US dollar is the benchmark by which other currencies are measured, it would be hard to trade in them as well.

Currencies could still be swapped at the going exchange rate (the so-called spot market), but Australian mining companies, super funds and exporters would be unable to buy protection against currency movements.

If it continued it would mean that many would find it safer to withdraw from international trade and investment.

Adding urgency was the time of year. Quarterly hedging contracts were about to expire.

Rather than wait even a few more hours for the US market to open, five central banks in Europe, Canada and Japan announced plans to sell as much as 180 billion US dollars to anyone who wanted them.

The US had agreed to funnel them the US dollars immediately. It was an emergency plan they had been cooking up for months.

It didn't involve the Reserve Bank of Australia this time, but next time it might - if there is a next time.

The very worst case is unthinkable - that financial flows between countries will stop. But a more likely outcome is in some ways worse - that trade will continue but that there will be less of it.